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17.14 Costs of Production

The costs of production for a firm are split into two categories. One type of cost, fixed costs, is independent of a firm’s output level. A second type of cost, variable costs, depends on a firm’s level of output. Total costs are the sum of the fixed costs and the variable costs.

The change in costs as output changes by a small amount is called marginal cost. It is calculated as follows:

marginal cost=change in total cost change in quantity =change in variable cost change in quantity .

Because fixed costs do not depend on the quantity, if we produce one more unit, then the change in total cost and the change in the variable cost are the same. Marginal cost is positive because variable costs increase with output. Marginal cost is usually increasing in the level of output, reflecting the diminishing marginal product of factors of production.

For example, suppose that total costs are given by

total costs = 50 + 10 × quantity.

Here the fixed cost is 50, and the variable cost is 10 times the level of output. In this example, marginal cost equals 10. These costs are shown in Table 17.5.

Table 17.5

Output Fixed Cost Variable Cost Total Cost
0 50 0 50
10 50 100 150
20 50 200 250
50 50 500 550

We sometimes divide fixed costs into two components: entry costs, which are the one-time fixed costs required to open a new business or set up a new plant, and fixed operating costs, which are the fixed costs incurred regularly during the normal operation of a business.

Some costs are sunk costs; once incurred, these costs cannot be recovered. Such costs should be ignored in forward-looking business decisions. Other costs are partially or fully recoverable costs. For example, if a firm purchases an asset that can be resold, then the cost of that asset is recoverable.

Figure 17.11 Cost Measures

Figure 17.11 "Cost Measures" shows these various measures of costs. It is drawn assuming a fixed cost of 50 and variable costs given by

variable costs = 10 × quantity + 0.1 × quantity2.

For this example, marginal cost is positive and increasing.

Key Insights

  • Fixed costs are independent of the level of output, whereas variable costs depend on the output level of a firm.
  • Pricing decisions depend on marginal costs.
  • Decisions to enter and/or exit an industry depend on both fixed and variable costs.